Shareholder Litigation And Corporate Innovation

Using a sample that contains 57,112 firm-year observations of public firms in the U.S.between 1976 and 2006, we find evidence consistent with “pressure hypothesis”.9 First, followingthe adoption of the UD laws, the treated firms invest more in innovation in terms of R&Dexpenditures. Second, the UD laws lead to greater engagement with explorative innovation.Specifically, firms are filing more patents in unfamiliar technological classes and producing morepatents based on new knowledge instead of existing knowledge. Finally, following the passage ofUD law, the treated firms generate more patents with a large number of citations and achievehigher patent value. The results imply that limiting managerial discretion through shareholderlitigation impedes explorative innovation activities. As shown in the dynamic analyses, the effectsof the UD laws tend to be long-term.We conduct a battery of empirical tests to alleviate endogeneity concerns related to reversecausality and omitted factors. First, we find no evidence that a firm’s innovative measuresreversely trigger the adoption of UD laws. We then show that the results remain unchanged whenconsidering state-by-year and industry-by-year fixed effects to control for trends at the state andindustry levels or using a sample that excludes the Internet bubble of 2000-2001. Some studiesimply that shareholder litigation alters corporate governance (Ferris et al. 2007). Following theadoption of the UD laws, the affected firms are more likely to use corporate provisions thatentrench managers and are also less likely to be held accountable by institutional investors (Appel2016). These contemporaneous changes provide more managerial discretion and might encourageinnovative activities. To explicitly control for this possibility, we add two proxies for corporategovernance, the G-index as in Gompers, Ishii and Metrick (2003) and institutional ownership andour results remain unaffected. Our results are also robust if additional board characteristics arecontrolled. Finally, we demonstrate the adoption of takeover laws do not confound our results.Building on our basic findings, we further conduct a subsample analysis to provide additionalevidence that the passage of UD laws stimulates innovation resulting from a reduction of theshareholder litigation threat. We find that the effects of lowered litigation risk on explorativeinnovation owing to UD laws are concentrated among firms in industries with a greater number ofderivative lawsuits, a proxy for the perceived litigation risk. We also document the effect isAlthough not consistent with the “disciplining hypothesis” in the context of innovation activities, our findings cannot lead to theconclusion that the shareholder litigation cannot effectively mitigate agency problems in other operating dimensions.95

primarily driven by firms with lower institutional ownership before the ruling suggesting ourresults are less likely to be driven by the potential exits of block shareholders following the lawadoption.This study provides the first evidence of the influence of shareholder litigation on innovationand makes several contributions to the literature. First, this study adds to the research on law andfinance. A large amount of literature has stressed the relevance of the securities laws andshareholder protection for capital market development. Much of this research, however, highlightsthe positive effect of the laws protecting the rights of shareholders (La Porta et al. 1998; La Portaet al. 2000; La Porta et al. 2006; Djankov et al. 2008). Particularly, Brown, Martinsson, andPeterson (2013) document that markets with strong shareholder protection achieve higher R&Dinvestment and innovation. Instead of focusing on the general rules of law, in this study weconsider a key shareholder protection mechanism: the right to shareholder litigation. In contrast tothe traditional wisdom, our evidence uncovers the circumstances under which shareholderprotection rights restrict managerial discretion and stifle corporate innovation. By looking at astate-level law adoption, this paper also relates to studies in the effect of public policies oninnovation and growth (e.g. Acemoglu et al. 2012; Aghion et al. 2001; Aghion and Howitt 2008;Bloom et al. 2002; Bloom et al. 2016; Lerner 2009).Second, our study contributes to the debate on the role of the capital market in motivatinginnovation. Recent empirical studies document a number of determinants for corporate innovationboth in positive and negative ways (see He and Tian 2017 for a review). Those factors includeinstitutional ownership (Aghion, Reenen, and Zingales 2013), leveraged buyouts (Lerner et al.2011), CEO compensation (Ederer and Manso 2013), non-executive employee stock options(Chang et al. 2015), analyst coverage (He and Tian 2013), venture capital (Kortum and Lerner2001), Chemmanur, Loutskina, and Tian 2014), financial dependence (Acharya and Xu 2017),credit default swaps (Chang et al. 2017), labor union (Bradley, Kim and Tian 2016), and boardmonitoring (Balsmeier, Fleming and Manso 2017). Shareholder litigation is mainly undertakenwhen other governance mechanisms fail in their monitoring roles (Romano 1991). Therefore, it isinteresting to examine whether one important type of shareholder protection rights, shareholderlitigation, impedes or incentivizes innovation. Our findings also highlight the underlying reasonswhy corporate governance might hinder the process of explorative innovation.6

Finally, our evidence sheds new light on the compelling debate over shareholder litigation. 10Some studies highlight the deterrence effect (Reinert 2014). Houston et al. (2018) finds reducedlitigation risk leads to higher cost of capital partially due to the deterioration of financial reportingquality. In contrast, there is an ongoing concern over the potential “dark side” of shareholderlitigation, which may play a larger role in the risky corporate activities, such as explorativeinnovation search. The agency costs rooted in the shareholder litigation process might generate alarge number of lawsuits with little legal merit (Fulop 2007). These lawsuits are not usually in thebest interest of the shareholders because they distract the managers and influence normal business.According to William R. McLucas, Director of SEC Division of Enforcement, “the SEC hasacknowledged the detrimental impact of meritless securities cases. To the extent that these claimsare settled to avoid litigation, they impose a tax on capital formation” (Seligman 1994). With thepurpose of mitigating this concern, the past two decades have witnessed a nationwide trend aimedat controlling meritless lawsuits. Both the UD laws and the Private Securities Litigation ReformAct (PSLRA) are intended to partially act as a barrier to abusive lawsuits brought by shareholders(Buxbaum 1980; Swanson 1992). In academia, however, researchers still hold different opinionson these policies. Some believe they have fulfilled their purpose, whereas others argue theunintended consequences such as the deterioration of corporate governance (Johnson et al. 2007;Appel 2016). In this study, we offer the first evidence suggesting that a regulation restricting therights of shareholders to litigate against their corporation, on average, incentivizes innovation.This study proceeds as follows. Section II discusses the institutional details and identificationstrategy. Section III discusses the sample construction and the definitions of the variables. SectionIV discusses the empirical results. We conclude in Section V.II. Institutional Background and Empirical Design2.1 Shareholder Derivative SuitsManagers and directors owe fiduciary duties to their shareholders, meaning that legally thosemanaging a corporation should do so in such a way that the best interests of the shareholders areserved. In reality, however, agency problems arise due to the separation of ownership and control,10This study focuses on shareholder litigation instead of the litigation of patents (see Lerner (2010) for a study on patentlitigation.)7

inducing managers to maximize their own interests at the shareholders’ expense (Jensen 1986). Inthe United States, shareholders may file lawsuits against their management for such wrongdoing.Litigation imposes personal liability on the officers and directors if they are found to have breachedtheir fiduciary duties (either duty of care or duty of loyalty). This helps to align the managers’incentives with the shareholders’ interests (Romano 1991).Shareholder judicial proceedings are mainly divided into two categories, direct suits, andderivative suits. In a direct suit, the lawsuit is brought up to remedy one shareholder or a subset ofshareholders (Ferris et al. 2007). For example, multiple shareholders in a defined “class” couldcommence a class action against firm’s management seeking compensation for common damagesin a particular period. The other type of claims from shareholders, derivative suit, is the focus ofthis paper.A shareholder derivative lawsuit is a legal action instituted by individual shareholders onbehalf of the company against their officers and directors for alleged wrongdoing that is harmfulto the entire corporate entity. The example of Tesla shareholder derivative suit can be found inAppendix 1. This type of shareholder lawsuit is derivative because the misconduct first harms thecorporation and then leads to the welfare deterioration of all shareholders. As a result, shareholderswho file derivative lawsuits are on behalf of the corporation instead of themselves. In the case ofTesla, the shareholder, Ross Weintraub, filed the lawsuit derivatively on behalf of the firm. Incontrast to class actions, in derivative actions, monetary recovery is paid to the company treasuryinstead of flows to the plaintiff shareholders. The importance of derivative suit has been recognizedin the law and finance literature. For example, La Porta et al. (1998) state that “the rights attachedto securities become critical when managers of companies act in their own interest Somecountries give minority shareholders legal mechanisms against perceived oppression bydirectors These mechanisms may include the right to challenge the directors’ decisions in court(as in the American derivative suit)”. And in typical cases of US, corporate policies that triggerderivative lawsuits include value-destroying investment decisions, information related activitiesand other issues about mismanagement (Ferris et al. 2007).11 Besides the US, some emerging11To increase the probability of winning the suit, shareholders usually allege these misconducts instead of directly accuse firm’sinnovation-related activities.8

economies such as India and China have also set up the law regarding shareholder derivative suits(Scarlett 2011).12Most of the large listed companies carry liability insurance for their directors and officers tocover the probable legal settlement costs. It is well documented that D&O insurance protects firm’sdirector and officers from personal liability in the event of litigation and could induce moral hazardproblem (Lin, Officer and Zou 2011; Lin et al. 2013). In most derivative suits, the settlement isfunded or partially funded by D&O insurance. However, D&O insurance typically cannot covermisconducts involving dishonesty or intentional wrongdoings (Ferris et al. 2007).13 Even if firm’smanagers do not need to personally pay the settlement fees, they will still face severe punishmentsfrom the reputation damages in the labor market (Fich and Shivdasani 2007). Firms will also bearheightened financing costs and stricter financing terms (Deng, Willis and Li 2014).Derivative suits publicize the agency problems within the firm and therefore deter directorsand officers from engaging with management misconducts in the future. However, these legalactions from shareholders are also accompanied by major concerns among researchers regardingthe legal merits of these claims (Fischel and Bradley 1985; Romano 1991).14 As discussed above,those lawsuits are usually driven by self-interested attorneys (Brandi 1993). And the detrimentalimpact of those lawsuits without merit is well documented in prior studies. As indicated by thecongress report in 1995, the shareholder litigation system shouldn’t “be undermined by those whoseek to line their own pockets by bringing abusive and meritless suits”. An abusive derivativelawsuit not only wastes a firm’s assets but also deter the management from risk-taking andexperimenting new ideas (Kinney 1994). The prevalence of excessive litigation induces officersand directors to focus more time on legally safe activities rather than on the far-sighted innovationthereby harming the competitiveness of the whole economy (Block, Radin, and Maimone 1993).12Laws regarding shareholder derivative litigation in emerging market typically resemble the derivative actions in US. TheIndia’s new Company Bill was introduced by the Ministry of Corporate Affairs and are clear about shareholder’s right to filingderivative lawsuits against mismanagement. Shareholder derivative action was first established through regional courts inShanghai and Jiangsu province and later written in China’s 2005 Company Law.13 For example, Lawrence J. Ellison, the CEO of Oracle agreed to pay 100 million to charity to settle a derivative lawsuit. Healso paid 22 million to plaintiffs’ counsel in legal fees and expenses related to the case. See lawsuit.html? r 014 Legal researchers commonly believe that most derivative lawsuit is meritless and mainly driven by the settlement fees insteadof corporate governance issues. The market does not upgrade the firm when the judicial decisions that allow a derivative suit tocontinue is announced (see in Fischel and Bradley (1985) and Brandi (1993)).9

2.2 UD LawsIn the US, the derivative suit proceeds in several steps. Before bringing a derivative action,the plaintiff shareholders must first demand that their board take action to address the allegedconcerns. This process is called the “demand requirement”. The board can choose to reject,consider or ignore the request within a reasonable time. But in reality, because the board membersare the ones usually targeted by the lawsuit, the directors almost always reject the demand.Shareholders can thus proceed with the derivative suit after the demand is refused or unanswered.But if the demand is rejected, in most of the cases, the court follows the board’s decision anddismisses the claim pursuant to the business judgment rule.Shareholders, however, can circumvent the demand requirement by arguing the futility ofdemand if they can provide evidence showing the board of directors cannot fairly evaluate it. 15 Inpractice, shareholders prefer to plead the futility exception, because it is difficult to proceed witha lawsuit if the board refuses the demand. In the case of Tesla, the shareholder argued that makingdemand would be futile because “current members of Tesla’s Board are antagonistic to thislawsuit”.Between 1989 and 2005, 23 states in the U.S. implemented the universal demand (UD) laws,which impose the demand requirement on every derivative lawsuit filed in states that have adoptedthe laws. After the enactment of the laws, shareholders are deprived of the option to plead demandfutility. As illustrated in Table 1, the earliest states to adopt the laws were Georgia and Michiganin 1989 and the most recent states to adopt them were Rhode Island and South Dakota in 2005.The idea behind the UD laws comes from the Model Business Corporation Act, a uniform lawproposed by the American Bar Association that is voluntarily followed by some states.16 Becausethe UD laws require plaintiffs to make a demand as a prerequisite to filing a derivative suit (asdiscussed above), and the demand would be refused in most cases, the universal demandrequirement serves as a significant barrier to filing derivative lawsuits. We document in what15Shareholders could argue futility if the board is believed to be responsible for the wrongdoing and therefore cannot makeunbiased decisions regarding the demand.16 As we will discuss later, we do not find systematic and obvious evidence suggesting the adoption of UD laws is driven bycorporate lobbying activities.10

follows that the number of shareholder derivative lawsuits has significantly dropped since the UDlaws were first adopted, a pattern consistent with the findings in Appel (2016).2.3 Identification StrategyFirms incorporated in the states that have passed the UD laws are relatively insulated fromshareholder derivative lawsuits for the reasons discussed above. We exploit these incorporationstate-level shocks as natural experiments to establish the causal relation between shareholderlitigation and innovation. This setting has several appealing empirical features that facilitate a validdifference-in-differences analysis. First, the variation in the litigation threat generated by thestaggered adoption of the UD laws is arguably exogenous to firm-level attributes. Second, similarto Bertrand and Mullainathan (2003), who evaluate the effects of the Business Combination Laws,the variation is at the incorporation state level. Empirically, this feature allows us to compare firmsthat are headquartered in the same state but are subject to different legislation. Firms incorporatedin states with UD laws are the treated firms, whereas those incorporated in states without UD lawsare the control firms. This empirical design significantly mitigates the confounding effectsresulting from regional economic shocks.Our diff-in-diff specification is as ��𝑡 𝛼 𝛽𝑈𝐷 𝐿𝑎𝑤𝑖𝑡 𝜃𝑖 𝛿𝑖𝑡 𝜀𝑖𝑡(1)where 𝐼𝑛𝑛𝑜𝑣𝑎𝑡𝑖𝑜𝑛𝑖𝑡 is the innovation measure gauged by several proxies. 𝑈𝐷 𝐿𝑎𝑤𝑖𝑡 equals oneif the incorporation state of the firm has a UD law.17 𝛽 is the main coefficient of interest to identifythe effect of UD law. 𝜃𝑖 denotes the firm fixed effects that capture all of the firm-level timeinvariant effects. 𝛿𝑖𝑡 represents the headquarter state by year fixed effects that pick up all of theheadquarter state level time-varying trends. In this model, we do not include any endogenousfactors as control variables. We estimate an alternative model as follows as a robustness 𝑡 𝛼 𝛽𝑈𝐷 𝐿𝑎𝑤𝑖𝑡 𝛾𝑋𝑖𝑡 𝜃𝑖 𝛿𝑖𝑡 𝜌𝑖𝑡 𝜀𝑖𝑡17(2)The treatment variable is assigned one starting from the first effective year of UD law throughout this study.11

We include a series of firm-level attributes as control variables, 𝑋𝑖𝑡 . The control variables includefirm characteristics such as size, leverage, book-to-market ratio, firm age and capital expenditure.In the robustness check, some proxies for governance, such as the G-index and institutionalownership, or an index of takeover susceptibility are also considered. Further, we consider industryby year fixed effects, 𝜌𝑖𝑡 , to account for the effects of industry-level trends.It is possible that the staggered adoptions of UD laws are not perfectly random. Economic,political or other unobservable factors could contribute to the spread of UD laws. But as we

shareholder litigation as an "uncontrolled tax on innovation".1 We investigate the impact of shareholder litigation on corporate innovation by relying on a staggered law change that reduces a manager's exposure to shareholder litigation.2 We explicitly test two conflicting hypotheses that can be drawn from the literature.